This Selected Issues paper analyzes the underlying factors that explain the behavior of the Kiwi dollar. The findings suggest that the factors influencing the New Zealand dollar have been changing. The paper discusses that as New Zealand has become more integrated in global capital markets over time, the Kiwi dollar has become less of a commodity currency and more of a global currency that is influenced by interest rate spreads and global risk factors. The paper also looks at the strong preference for housing over financial assets exhibited by New Zealand households.

27. This chapter looks at the strong preference for housing over financial assets exhibited by New Zealand households. The large weight of housing in household portfolios merits consideration because of possible negative consequences for households and for macroeconomic performance. This chapter examines a number of reasons for the “home bias” of New Zealand households, and focuses on the taxation of housing investments. Investment properties in New Zealand enjoy a number of tax advantages, that are not available in other countries, and these may have contributed to the recent housing boom. Finally, the chapter considers the policy actions which may strengthen interest in the financial assets and dampen enthusiasm for housing assets, without introducing distortions into the system.

A. “Home Bias”: the Facts

28. Housing assets make up a large portion of New Zealand households’ portfolios. Non-financial assets (which consist mostly of housing) made up 76 percent of total assets of New Zealand households in 2006. This ratio is significantly higher than in most other OECD countries, and compares to around 60 percent in Australia, 50 percent in the United Kingdom, and 40 percent in the United States. Total housing assets are equal to 570 percent of household disposable income in New Zealand, also among the highest in OECD.

Households’ non-financial assets to total assets, percent

Source: Reserve Bank of New Zealand (RBNZ)

29. The preference for housing over financial assets has strengthened in recent years, driven to a large extent by house prices. Until early 1990s, the share of financial assets in total household assets fluctuated at around 40 percent – similar to the current level in Australia and Germany, and higher than that in France. The ratio fell to around 35 percent in mid-1990s, and then dropped to 24 percent in 2001-06. The latest decline was largely driven by the increase in house prices: between 2001 and 2006, house prices in New Zealand were increasing by 15 percent a year on average, and households’ net equity in housing increased from 240 percent of disposable income to over 500 percent.

30. The difference with the structure of households’ portfolios in Australia is remarkable. The share of financial assets in Australian household portfolios rose above that in New Zealand in mid-1990s. What is remarkable, however, is that the Australian housing boom of 2000-03, although of similar magnitude to New Zealand’s, resulted in only a minor decrease in the ratio of financial to total assets, and the ratio rebounded after the house prices stopped increasing. In other words, Australian households appear to have reallocated some of the wealth created by the increase in house prices into financial assets. This is confirmed by the finding that Australia featured substantial home equity withdrawal (HEW) in recent years (Klyuev and Mills, 2006), and that two thirds of Australian HEW was used to acquire financial assets or pay off debt (RBA, 2005). In New Zealand, on the other hand, HEW was unknown until 2003, and available survey data suggest that proceeds from HEW are mostly used to finance home improvements and to purchase consumer durables (Smith, 2006).

Households’ Financial Assets to Total Assets (Percent)

Source: Reserve Bank of Australia (RBA) and RBNZ

31. New Zealanders’ holdings of equity appear to be particularly low. The direct holdings of both domestic and foreign equity make up only about 4 percent of total household assets in New Zealand (Bollard, 2006). Indirect holdings of equity via superannuation schemes, managed funds, and unit trusts account for another 2 to 3 percent of household assets, also low by international standards. Holdings of unlisted equities are likely to be greater, because of a large number of small firms and farms, almost all privately owned, often through family trusts. There are a number of statistical complications with the treatment of family trusts, which suggest that equity holdings of the household sector may be underestimated (Briggs, 2006). Furthermore, the offshore equity holdings by New Zealanders may also be underestimated in the official data. Nevertheless, even with these statistical issues in mind, holdings of equity by New Zealand households appear to be significantly lower than in other industrialized countries.

B. Is “Home Bias” a Problem?

32. The large weight of housing in portfolios has negative consequences for households. The lack of portfolio diversification, with a high exposure to such a lumpy and illiquid asset as housing, increases the sensitivity of households to falls in house prices. The focus of households on housing assets may also tend to drive house prices higher compared to income than they would be otherwise. Furthermore, since house purchases are typically financed by mortgage debt from the banking system, high exposure to housing increases household indebtedness. In 2006, total debt of New Zealand households reached 160 percent of disposable income, and debt servicing burden exceeded 13 percent of disposable income, significantly higher than in most OECD countries (OECD, 2006). This raises concerns about the vulnerability of households to adverse interest rate and unemployment shocks, although at the moment this vulnerability does not appear to be a threat to systemic stability (see Chapter III).

33. The strong preference for housing may also affect macroeconomic performance. The large share of housing in households’ portfolios amplifies the wealth effect of rising house prices. This may be one of the reasons for the apparently higher sensitivity of consumption to house prices in New Zealand, compared to Australia and the United Kingdom. This high sensitivity is likely to be one of the factors behind the decline in the savings rate in recent years (Bollard et al, 2006, Goh, 2005). In addition, the preference for housing assets over equity may result in less equity capital being available to finance risky investments (such as startups), potentially reducing financing of investment and growth (Bollard, Drage, and Orr, 2007). This might explain the high use of home mortgages for raising business capital – according to RBNZ estimates, around 10 percent of total mortgage lending is used to finance business.

Ratio of Private Consumption to Potential Output

Source: RBA, RBNZ, and staff calculations

C. Possible Reasons for “Home Bias”

Investor Protection

34. Low level of investor protection can be a reason for the lack of development of financial markets; however, this does not apply in New Zealand. A strong link between the level of investor protection and the level of financial markets development is well established in the literature (La Porta et al, 1997). However, New Zealand has one of the highest possible scores for the index of shareholder (as well as creditor) rights. These indices capture only the most basic features of legislation that are believed to be necessary for adequate investor protection. A full assessment of investor protection would require analysis of investor protection environment and of the quality of implementation of existing legislation. Nevertheless, it appears safe to assume that the level of legal protection is not the reason why most New Zealanders are reluctant to invest in financial assets.

Index of shareholder rights (Maximum possible value = 5)

Superannuation System

35. The existence of national superannuation schemes could contribute to a lack of investment in financial assets. It is possible that superannuation makes some households feel that they do not need additional private savings to finance their consumption in retirement. This would explain a low private savings rate, as well as low holdings of financial assets. However, in Australia, the introduction of the current compulsory superannuation system in the early 1990s did not produce a decrease in the share of financial assets in households’ portfolios. The main effect of superannuation was a change in the structure of households’ financial assets (a decrease in the shares of deposits and unfunded superannuation claims, and an increase in the shares of equities and pension funds). However, the superannuation schemes in Australia are different from those in New Zealand (in particular, the age pension in Australia is less generous than New Zealand superannuation).

Australia: Composition of Households’ Financial Assets

Source: RBA

Wealth Inequality

36. Low wealth inequality in New Zealand may offer a partial explanation for low holdings of equity. Households typically begin to invest in equity only after reaching a certain level of wealth. Thus, equity holdings tend to be concentrated in wealthier households. This would imply that holdings of equity will be higher in countries where wealth inequality is higher, which is confirmed by a simple scatter plot. However, even after taking the wealth distribution into account, New Zealand appears to be an outlier, with equity holdings lower than in other countries with similar distribution of wealth.

Wealth Inequality and Equity Holdings

Source: World Institute for Development Economics Research of the United Nations University (UNU-WIDER) and RBNZ

Investor Literacy and Financial System Development

37. Survey data show a lack of understanding of share market returns in New Zealand, as well as a lack of investment skills. A Financial Knowledge Survey conducted in 2006 by the ANZ bank and the Retirement Commission indicated that, while most New Zealanders have a good basic understanding of financial concepts, there are some topics (such as compound interest, mortgages, and investment) that are not well understood.16 Over half of respondents expressed strong preference for fixed-interest investment over shares as a long-term investment option. Furthermore, about 20 percent of respondents believed that investing only in property was a way to reduce investment risk.

38. Past experience may increase the perception of the relative safety of investment in housing. Housing has proved to be a reliable investment in New Zealand in the past. New Zealand has not experienced significant housing market busts (although real house prices have declined in several episodes), and during the period of high inflation in the 1970s and 1980s, returns on housing were better than those on bonds and other fixed- interest financial assets.17 By contrast, the experience of the 1987 stock market crash was especially severe in New Zealand. As a result, the stock market is perceived by many to be significantly more risky and less reliable than the housing market, even in the long term. In reality, however, gross returns on a broad New Zealand stock market index have closely tracked the housing inflation over the last decade, albeit with higher volatility.

Returns on Equity and Housing, Unadjusted for Taxes

Source: Quotable Value Ltd, RBNZ, and Statistics New Zealand.

39. Some features of New Zealand financial system may also contribute to the lack of interest in financial assets. While the New Zealand banking system is deep by international standards, and the banks are sound and efficient (see Chapter III), other sectors of the financial system are relatively less developed. In particular, the equity market is shallow and has low turnover, and the corporate bond market is also relatively small (Beck, Demirgüç-Kunt, and Levine, 2006). While it is difficult to establish the direction of causality (lack of investors may be slowing the development of financial markets), it is remarkable that New Zealanders invest twice as much in equities directly compared with managed funds (Bollard, 2006). Analysts often attribute this to a “do it yourself” investment culture, and to a strong mistrust of investment advisors and managed funds.18 Whatever the reason, however, the result is that many households do not make diversified investments in the stock market, since it is very difficult to invest in a broad market index without using a managed fund.

Taxation of Housing

40. The tax system can have an important impact on investment returns. This section analyzes post-tax returns on various investments. The way the tax system treats capital gains on investments, and (in the case of housing) mortgage interest and depreciation, can have a major impact on the relative attractiveness of different investment options.

41. There are important differences between the tax treatment of housing in New Zealand and in other OECD countries. Property taxes in New Zealand are about 2 percent of GDP, in line with the OECD average.19 However, there are important differences in the way interest, depreciation, and capital gains on property are treated (Table II.1). In particular, property investors in New Zealand are able to deduct both mortgage interest and depreciation from income, and are able to use negative gearing.20 In addition, property investors are almost never taxed on capital gains.21 While none of those elements of the tax system is unusual by itself, their combination makes New Zealand stand out from other OECD countries.

42. The current tax system favors housing over equity investments. Capital gains on equity investments are also typically not subject to tax, unless they are made through managed funds (index funds are exempt). However, the possibility of deducting interest and depreciation from taxable income provides an advantage to investments in housing, which are typically at least 80 percent leveraged. This advantage is not available to owner-occupiers, but can be used by investors in rental property.

43. To assess the impact of the taxation system on returns from investing in housing, it is useful to begin with a simple hypothetical example. A base case is considered first, with rental yield and house inflation set at 5 percent, and the mortgage interest rate at 10 percent. The effect of an increase in house inflation and rental yield, and of a decrease in the mortgage rate can then be analyzed (Table II.2).22 The results show the importance of the ability to deduct interest and depreciation. Even in the base case scenario, with a high mortgage rate compared to rental yield and capital gains, investors in housing would be able to receive a sizable return on their investment, once all tax deductions are taken into account. Not surprisingly, of all the scenarios considered, an increase in house inflation is the most beneficial for the investors (the untaxed capital gains increase, with all tax deductions unchanged). A decrease in the mortgage rate, on the other hand, reduces interest expenses, but at the same time cuts the tax gain from the interest deduction, and therefore has a much smaller effect on returns.

44. The next step is to estimate the actual returns realized by investors in housing and stock market in the past decade.Table II.3 shows the calculation of returns for the last three years, and for the 10-year period 1997-2006. Returns are also calculated separately for the period of the housing boom (2004-06) and for the period before the boom (1997-2003).

45. Calculations show that over the past decade, investors in housing enjoyed returns that were superior to stock market returns, for several reasons. One of the key reasons is the ability to leverage housing investment, which has been especially important in recent years when house price inflation by far exceeded the effective mortgage rate.23 However, even during the period of relatively small house price increases (1997-2003), the rental yield and house price inflation together exceeded the gross stock market return, and the ability to leverage allowed investors in the housing market to obtain superior returns. The deductibility of depreciation and interest from taxable income further increases returns from investment in housing. The gain from tax deductions depends mainly on the mortgage and tax rates, and is therefore especially important in times of low house price increases: in 1997-2003, tax deductions allowed housing investors to double their returns.

46. Calculations also show that taxing capital gains would reduce but not eliminate the advantages of investment in housing. Table II.3 shows the amounts that housing investors would have to pay if a capital gains tax was levied at a rate equal to 50 or 100 percent of the marginal tax rate.24 Although a capital gains tax would substantially reduce the returns on housing investments, these returns would remain extremely attractive. During the period of relatively slow growth of house prices (1997-2003), even a capital gains tax at the marginal income tax rate would not fully eliminate the gain from the mortgage interest deduction.

47. For owner-occupiers, there are fewer tax advantages from investing in housing. While owner-occupiers are also not taxed on capital gains, they cannot deduct interest or depreciation from taxable income. Nevertheless, even for them, capital gains during the recent housing boom substantially exceeded mortgage interest, making house ownership an attractive proposition.

48. The importance of investors in housing from the macroeconomic point of view is likely to be substantial. No comprehensive analysis has been done to determine whether investment property transactions have played a disproportionate role in the housing boom of recent years.25 However, banks indicate that about 30 percent of housing loans issued in recent years were for purchases of rental housing. This is consistent with staff estimates based on changes in the owner-occupation ratio during 1990-2004. RBNZ estimates that most landlords sell rental properties within 4 years – an indication that properties may often be purchased mainly for capital gains, rather than rental yields. Finally, Australian experience shows that investor activity in the residential property market has been a key driver of the recent property boom (Parlett and Rossiter, 2004), with many investors pursuing the negative gearing strategy that is allowed by both Australian and New Zealand tax rules.

D. Policy Implications

49. Investor education and some improvements in regulation may strengthen interest in financial assets. The memories of the market crash of 1987 will naturally fade over time, and investor education can improve understanding of returns, mortgages, and other investment concepts. Various project currently being undertaken by the Retirement Commission, Ministry of Education, and Enterprise New Zealand Trust to improve financial education are aimed at improving financial literacy in the long-term.26 Studies conducted in OECD countries show that financial knowledge generally increases with income, education, and net worth (OECD, 2005), and New Zealand is well placed to achieve rapid progress in this area. In addition, improvements in regulation of managed funds, and better transparency, could help overcome the distrust of fund managers. The main objective of the Review of Financial Products and Providers, led by the Ministry of Economic Development, is to ensure that regulation promotes confidence and participation in financial markets. Proposals made under this review would enhance the disclosure regime for securities offerings, by making disclosure more accessible for consumers.27

50. Tightening of tax rules applying to housing investment could help dampen enthusiasm for housing assets. Measures that deserve consideration include (i) not allowing operating losses on investment properties to be offset against other taxable income; and (ii) strictly enforcing the current law making gains on non owner-occupied properties purchased with the intention of resale subject to income tax. Both these measures were examined in the context of the Supplementary Stabilization Instruments (SSI) report,28 and the RBNZ has recently indicated that they are still under consideration.29 The second of these measures involves strict enforcement of the existing law, and would at this stage be preferable to a general capital gains tax on real estate.

51. Measures that would introduce distortions in the housing market should be avoided. The SSI report also considered introducing a limit on the loan to value ratio for all loans secured by residential property, and a discretionary mortgage interest levy. While both these measures could have a dampening effect on the housing cycle, they are distortionary and should be avoided. Both measures would also have the biggest impact on lower income borrowers. In addition, a mortgage interest levy would raise the cost of residential mortgage loans relative to other types of credit, irrespective of relative risk considerations.

References

BeckT.A. Demirgüç-Kunt and R. Levine2006 an update of Beck T. A. Demirgüç-Kunt and R. Levine2000 “A New Database on Financial Development and Structure,” World Bank Economic Review 14 597–605.

Survey results suggest that many investors consider the fees charged by managed funds excessive, too complex, and non-transparent. In addition, capital gains from equity investments by managed funds are typically taxed, while capital gains from investments by individuals are not.

Negative gearing is defined as the “practice of allowing those who have borrowed to finance the purchase of assets to deduct from their other taxable income the excess, if any, of the resulting interest payments over the cash flows, net of other expenses, from these investments” (Fane and Richardson, 2005).

In principle, capital gains on property are considered taxable income in New Zealand if the property was acquired for the purpose of resale (Oliver, 2000). However, in practice this tax is easy to avoid, as long as the business plan shows that the acquisition is being made because of rental yield, not capital gain.

Calculations of returns on housing investments in Tables II.2 and II.3 do not take into account closing costs and fees related to a purchase and subsequent sale of a house. These costs are estimated to be less than 2 percent of the current median house price, and should not affect the results.

Most stock market investments by households are not leveraged. However, Table II.3 shows that, given the volatile nature of the stock market, leveraging equity investment at 80 percent at the prevailing lending rate is a highly risky strategy, which produces negative returns in the periods of relatively slow growth in equity prices.